Over the past couple of decades, stock-for-stock mergers have only accounted for 20% of the total M&A activity in the United States. On the other hand, in India, mergers rarely involve a cash consideration and are usually pure share swaps given the tax neutrality available for pure share swap transactions in India. However, mergers comprise only a fraction of the M&A activity in India as companies usually prefer the ease of share purchase or asset purchase transactions.
In light of the widespread economic uncertainty caused by the COVID-19 pandemic, acquisitions can pose to be difficult on account of stretched financial resources and risk-averse lenders. Nevertheless, the pandemic also presents a key opportunity as a number of companies are undervalued and in need of capital infusion. In this article, we highlight the key regulatory and practical considerations affecting share swap mergers in India.
Under Indian company law, a merger is a tribunal-driven process which requires the approval of the National Company Law Tribunal (the “NCLT”). A merger statutorily requires the approval of at least 75% of the relevant shareholders and creditors in value. Further, a merger may also be scrutinized by the Central Government, the income tax authorities, the Reserve Bank of India (the “RBI”), the Securities Exchange Board of India, the Registrar of Companies, the stock exchanges and the Competition Commission of India. Given this, a merger is often more time-consuming and onerous than a simple acquisition of shares or assets.
Under Indian tax law, in order for a merger to be tax neutral, the merger must fulfil the following conditions:
all assets and liabilities of the amalgamating company must be transferred to the amalgamated company; and
at least 75% of the shareholders (in value) of the amalgamating company must become shareholders of the amalgamated company.
Indian tax law provides a capital gains tax exemption to shareholders of the amalgamating company if:
such shareholders receive shares in the amalgamated company in consideration of the transfer; and
the amalgamated company is an Indian company.
The key is to structure the merger in a tax efficient manner to ensure tax neutrality and exemption from capital gains, both, in the hands of the amalgamating company and the shareholders of the amalgamating company. Also, tax authorities usually look at schemes of amalgamation closely which involve transfer, carry forward and set-off of losses of the amalgamating company solely from the perspective of tax avoidance. Largely, a scheme of amalgamation approved by the NCLT is considered to be tax neutral unless the Indian tax authorities apprehend the scheme to be designed for tax avoidance or to be contrary to the general anti avoidance rules (GAAR).
In addition to the foregoing, cross-border mergers involving Indian companies are also governed by Indian foreign investment regulations and are subject to the supervision of the RBI. In 2018, the RBI notified the Foreign Exchange Management (Cross-Border Merger) Regulations, 2018, which mandates the requirement of a prior approval of the RBI for cross-border mergers unless such mergers comply with certain prescribed conditions.
For inbound mergers, i.e., mergers pursuant to which the amalgamated company will be an Indian company, the prescribed conditions include, inter alia, the following:
Issuance of shares by the amalgamated company to non-resident shareholders must comply with the prescribed entry routes, sectoral caps/conditions and reporting requirements;
Any overseas office of the amalgamated company must comply with the prescribed requirements of an overseas branch office; and
All guarantees or outstanding borrowings of the foreign company availed from an overseas lender must comply with India’s foreign exchange regulations on guarantees and external commercial borrowings within two (2) years from the merger being effective, except in respect of the end-use restrictions.
Similarly, for outbound mergers, i.e., mergers pursuant to which the amalgamated company will be a foreign company, the prescribed conditions include, inter alia, the following:
Issuance of shares by the amalgamated company to Indian residents must comply with the prescribed regulations on overseas investments by Indian residents;
Any office of the amalgamated company in India will be deemed to be a branch office and must comply with the prescribed regulations on establishment of branch offices by persons resident outside India; and
All guarantees or outstanding borrowings of the Indian company which are acquired by the amalgamated company must be repaid as per the approved merger scheme.
Given the foregoing, a cross-border merger will likely be a viable route only if commercial considerations warrant a merger as opposed to a buy out and the merger satisfies the prescribed conditions, as obtaining an approval from the RBI is likely to significantly lengthen the timeline and increase the costs of the transaction. Additionally, NCLT approval is also required for, both, inbound and outbound cross-border mergers.
A share swap merger is likely to result in certain governance and post-integration issues. From a corporate governance standpoint, the companies may have to negotiate on composition of the board of directors of the amalgamated company to include certain erstwhile directors of the amalgamating company, as well as the extent of dilution of shareholding of the existing shareholders of the amalgamated company, their veto rights and their ability to drive management decisions. All these concerns will have to be weighed in the context of a share swap merger vis-a-vis a share sale or an asset sale transaction given the availability of finance at compellingly low interest rates.